Fin-301 Project

CHAPTER 7
Risks of Financial Institutions

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©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

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Overview
This chapter discusses the risks faced by financial institutions:
Interest rate risk, market risk, credit risk, off-balance-sheet risk, foreign exchange risk, country or sovereign risk, technology and operational risk, liquidity risk, and insolvency risk
Note: These risks are not unique to FIs
Faced by all global firms

Ch 7-*
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Risks of Financial Intermediation
Interest rate risk results from mismatch in asset and liability maturities:
Spread changes as interest rates change
Since value = PV(Cash flows), equity affected
Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs
Inconsistent with active asset transformation function
Reinvestment/refinancing
Market value risks

Ch 7-*
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Credit Risk
Risk that promised cash flows will not be paid in full
High rate of charge-offs of debt in the 1980s, most of the 1990s, and 2000s
Charge-offs continued to grow until late 2008
Firm-specific credit risk
Systematic credit risk

Ch 7-*
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Ch 7-*
Charge-Off Rates for Commercial Banks
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Implications of Growing Credit Risk
Importance of credit screening and monitoring
Diversification of credit risk
Loan sales, reschedulings, good bank-bad bank structure
Credit derivatives

Ch 7-*
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Liquidity Risk
Risk of being forced to borrow or sell assets in a very short period of time
Low prices result
May generate runs
Runs may turn a liquidity problem into a solvency problem
Failure of IndyMac in summer of 2008

Ch 7-*
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Foreign Exchange Risk
FI may be net long or net short in various currencies
Returns on foreign and domestic investments are not perfectly correlated
Technological and economical differences
FX rates may not be correlated
Example: $/€ may be appreciating while $/¥ falling
Undiversified foreign exposure creates FX risk

Ch 7-*
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Note that fully hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities, as well*
Otherwise, exposure to foreign interest rate risk remains

* More specifically, FI must match durations, rather than simple maturities. See Chapter 9.
Ch 7-*
Foreign Exchange Risk Continued
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Country or Sovereign Risk
Risk that foreign borrowers may be unable to repay due to interference from foreign governments
Type of credit risk
Often lack usual recourse via court system
Example:
Argentina

Ch 7-*
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In the event of restrictions, reschedulings, or outright prohibition of repayments, a FI’s remaining bargaining chip is future supply of loans
Weak position if currency collapsing or government failing

Ch 7-*
Country or Sovereign Risk Continued
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Market Risk
Incremental risk incurred by FI when interest rate, FX, and credit risks are combined with an active trading strategy
Short trading horizons
Financial crisis of 2008-2009
Mortgage-backed securities
“Toxic” assets
Lehman Brothers, Merrill Lynch, AIG

Ch 7-*
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Market Risk Continued
Present whenever a FI takes an open or unhedged long (buy) or sell (short) position in securities, FX, or derivative products, and prices change in a direction opposite to expectation
Implications for regulators and management:
Need for controls
Need for measurement of risk exposure

Ch 7-*
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Off-Balance-Sheet Risk
Striking growth of off-balance-sheet activities
Letter of credit
Loan commitments
Derivative securities
Contingent assets and liabilities
Direct impact on future profitability and performance of FI

Ch 7-*
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Technology and Operational Risk
Risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events
Target hacking incident in 2013
Heartland Payment Systems
“the London Whale”
Operational risk includes technology risk

Ch 7-*
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Technology Risk
Technological innovation has seen rapid growth
Automated clearing houses (ACH)
CHIPS
Real time interconnection of global FIs via satellite systems
E.g., Citigroup

Ch 7-*
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Economies of scale
Economies of scope
Operational risk not exclusively the result of technological failure
Employee fraud and errors
Losses magnified since they may result in loss of reputation and future business

Ch 7-*
Technology and Operational Risk Continued
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Insolvency Risk
Risk of insufficient capital to offset sudden decline in value of assets relative to liabilities
Original cause may be excessive interest rate, market, credit, off-balance-sheet, technology, FX, sovereign, and liquidity risks
Washington Mutual
“Too big to fail” (e.g., Citigroup)

Ch 7-*
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Other Risks and the Interaction of Risks
Interdependencies among risks
Example: Interest rate, credit and off-balance-sheet risks
Example: Liquidity, interest rate and credit risks
Discrete risks
Examples include effects of war or terrorist acts, market crashes, theft, and malfeasance
Changes in regulatory policy

Ch 7-*
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Pertinent Websites
Bank for International Settlements
Federal Deposit Insurance Corporation
Ch 7-*

www.bis.org

www.fdic.gov

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